Investing In China: The "china Fallacy"?

China has long been an entrepreneur’s daydream – “If I could sell one pair of underwear each to a billion Chinese…”. Now, after almost 25 years of opening its gates to the outside world, how well are things working?
In practice, there have always been two clearly separate strategies for taking advantage of China’s

1.3 billion people - (1) to use China’s low labor costs to produce cheaply and then export to more affluent markets for a higher mark-up, and (2) to sell products to Chinese people. There is no debate over the fact that up until now, strategy (1) has worked better – over most of the last 25 years the average Chinese consumer hasn’t had enough disposable income to buy Western products in any significant quantities. But all that is changing. China’s emerging middle class is now estimated to be larger than the entire population of the United States (although their purchasing power is nowhere near that of the American middle class). So are foreign investors raking in their long dreamed-of windfall products by selling their products to the middle class? Well, not exactly…
Information on corporate profits broken down for affiliates in China is surprisingly hard to come by, and thus opinions are divided on this issue. While almost everyone in the know agrees that corporate profits from China operations have been on the upswing in recent years, the pessimists insist that overall profitability lags far behind that of some of America’s less-acclaimed trading partners like Mexico, and even further behind if you measure on a per capita basis rather than total population. The optimists (using different sources of data) maintain that profitability in China has been consistently high and point out that the proper comparison between the profitability of investments in different nations is not between China’s 1.3 billion people and the population of some smaller trading partner, but between the amount of investment in each country – the US, for example, has invested nearly twice as much money in Mexico as it has in China. Both sides agree on two things, though: (1) foreign investment in China (particularly from the US) is not nearly as much as has been supposed, and (2) corporate profits in China look to increase over the near to medium term due to the increase in disposable income among China’s middle class.
In light of this, what would a good strategy be for a prospective foreign investor? The current conventional wisdom seems to be to hedge your bets – produce partly for export and partly for the domestic market, leaving some flexibility in your plans to allow for the unexpected. It would also be a good idea to factor in the likelihood that sales in the China market are likely to increase over time. Of course, that’s what people have been saying for the last 25 years, but there is a growing chorus of voices predicting that now it’s different, that the timing is right, that the China profit train is poised to finally take off. I for one believe them.